(PUB) Investing 2015

Morningstar FundInvestor

November 2015

case in which a firm was charged with violating regu-

lations meant to ensure that it appropriately pay

and account for sales and marketing expenditures, and

that violation harmed every shareholder in its funds.

(Accordingly, we’ve lowered our Parent Pillar rating of

First Eagle funds to Neutral from Positive.) Second,

it’s symbolic of the lengths to which firms have gone in

pushing the limits of rules governing the practice of

using fund assets to pay for sales and

marketing activities.

Transfer agents handle the fairly mundane work of proc-

essing mutual fund transactions, making distributions,

calculating cost basis, and more. A fund’s transfer agent

can be affiliated with the fund company, or it can

be a third-party firm. In either case, transfer agents will

sometimes elect to outsource at least a portion of

the work to a sub-transfer agent. For instance, a fund

company that acts as the transfer agent of a fund

that it offers might elect to outsource the transfer agency

work to a brokerage house if that fund is offered

on the brokerage house’s platform. In that scenario,

the fund pays—from its assets—the brokerage

house for its services. This is pretty straightforward and

entirely permissible.

What has piqued the

SEC

’s interest, though, is the

nature of the services being rendered under some of

the sub-transfer-agency agreements it has examined.

To be clear, the issue here isn’t necessarily that fund

companies overcharged their shareholders. Rather,

it’s whether they’ve disguised sales and marketing

expenses as sub-transfer-agent fees. Indeed, that’s

what the

SEC

found at First Eagle, which had entered

into two sub-transfer-agency agreements that

included explicit provisions linking sub-transfer-agency

fees to sales of First Eagle funds on the brokerage

houses’ platforms, a no-no.

The

SEC

imposed a

$12

million penalty on First

Eagle and additionally ordered it to compensate investors

for damages amounting to

$25

million plus

million in interest. Spread out over more than

$60

billion

in mutual fund assets under management, it’s a

pretty small amount, but there are some important

principles involved:

Competition intensifies when it’s out in the open. For

instance, the incursion of lower-cost vehicles like

exchange-traded funds into the U.S. fund industry has

exerted downward pressure on prices across the

market. But when firms use subterfuge like mislabeling

sales and marketing expenses, it short-circuits

competition and, ultimately, short-changes investors.

While management fees have ticked lower, sales and

marketing expenses have been more-or-less impervious

to that trend. Why? One could argue that, far from

being out in the open, they’re largely concealed in fund

expense ratios (where they’re levied as

fees).

So is it any wonder they haven’t come down? Fund com-

panies often feel they have little choice but to pay to

be in key platforms and supermarkets, and those fees

have actually risen during the past decade.

Even when you set up a system to police the bundling

of sales and marketing fees, you have excesses at

worst, confusion at a minimum. Indeed, fund account-

ing is apparently so opaque, or subject to interpre-

tation, that fund firms sometimes have to engage

outside consultants and legal counsel to vet their

agreements and the way they’ve classified the associ-

ated costs. (First Eagle reportedly did so, to no avail.)

The market has voted against the bundling of sales

and marketing fees. How? They’ve moved en masse

into products like index funds and

ETF

s that don’t

charge these fees. So while the traditional fund

industry might have won the battle to avoid having to

pay for all of these fees out-of-pocket (as opposed

to paying from fund assets, the prevailing method),

it looks like it’s losing the war.

It’s an open secret in the industry that the costs of putting

a fund in a retirement plan, brokerage platform, or

supermarket are greater than the fees explicitly allotted

for distribution. The cost for this distribution is gen-

erally covered by

fees, which are the only fees

that can be used for such purposes from a fund’s

assets. Other fees come from a class of fund expenses

deemed “administrative” or related to “shareholder

service” and may involve transfer agents, sub-transfer

agents, and other parties unfamiliar to most

individual investors.